A Marriage of Convenience: Private Equity and Hedge Funds

While convergence between hedge funds and private equity funds seems inevitable, funds must weigh both the benefits and the potential pitfalls of taking the plunge.

"Convergence" is a term increasingly being used in the alternative investments community to describe what many observers view as the inevitable coming-together of private equity and hedge funds. What forces are driving this trend toward convergence of these two investment sectors, and what is the likely impact?

Both industries are at a juncture where they find themselves looking for new opportunities for growth. Over the past several years, assets under management in hedge funds have swelled to more than US$1 trillion in roughly 9,000 funds. During the same period, the private equity industry also has grown substantially and now has about $150 billion in assets under management in roughly 3,000 funds.

Historically, hedge funds and private equity funds have been distinct alternative investment categories for investors. The single thing they have had in common is that they both represent private pools of capital. All other facets of their business are different, including the way fund managers invest their capital, the types of investors they woo to invest in their funds, the cultures within the organizations that manage the funds, and the type of employees they attract.

Traditional hedge funds generally seek market inefficiencies and pricing anomalies to achieve their absolute-return market goal. It's not uncommon for a hedge fund to hold on to its securities for minutes, hours, or days, and to take both long and short positions in securities. Their portfolios are generally well-diversified, well-leveraged, and hold no more than a small interest in any single company.

Traditional private equity funds, in contrast, create value in their funds by working with or taking over the management of the companies within which they invest over a relatively long period. An investment may be passive or one where the private equity fund has significant influence over the investee company, including, in many cases, actual control of the company. The investee company may be a public entity or may consist of privately contracted equity stakes where no readily available market exists.

Hedge Funds Vs. Private Equity
Hedge Fund Private Equity
Term Unlimited Usually 10 to 12 years
Type of investments Fairly liquid (including complex derivatives) Illiquid
Investors' liquidity Open-ended fund, with periodic withdrawals possible Closed-end funds. Distributions are made at the discretion of the general partner
Capital contributions 100% contribution at subscription date Based on capital commitment drawdown over time
Management fees Based on net asset value Based on capital commitments
Performance-based compensation Incentive fee taken annually on realized and unrealized gains, no "clawback" Carried interest on realized investments, subject to "clawback"

What Would Funds Gain?

To understand what is fueling the talk about convergence, we first have to define what it means. Convergence between the two sectors could be achieved in one of two ways: either as hedge fund participation in private equity-style investing, or as the management of private equity funds and hedge funds as separate investment vehicles under one roof.

Benefits for Hedge Funds. As more and more hedge funds are formed and markets become crowded from overparticipation, hedge fund managers have been seeking new opportunities for deploying their capital. The huge inflows of capital into hedge funds mean that they can deploy their capital diversely. Hedge funds historically have focused on investing in global equities, convertible and other fixed-income securities, high-yield bonds, distressed markets, and various derivative products. In addition, they have invested in real estate and have become involved in making bridge loans and other loans, including those traditionally made by banking institutions.

However, hedge funds seek absolute returns year after year, and they are finding it more difficult to produce double-digit returns in the markets in which they currently trade. Private equity investing produces opportunities for them to earn the higher returns they seek and is the next logical step in broadening their trading strategy.

Appeal for Private Equity Funds. For private equity funds, being teamed up with hedge funds also produces benefits. Given the nature of a private equity investment, the funds usually require longer lock-up periods that may deter investors. Most private equity investments are held for longer periods of time, and in some cases investors may wait more than a decade for a return to be realized. Some of these private equity investors may welcome the opportunity to invest in hedge funds to gain the liquidity that hedge funds provide. An affiliation between a private equity fund and a hedge fund would allow the private equity fund to direct investors to its affiliated hedge funds, allowing investors to diversify their holdings. This becomes advantageous for private equity investors when trying to subscribe into popular hedge funds that are no longer accepting subscriptions from new investors.

In addition, as private equity investments return capital, which in turn leads to distributions to investors, these same investors may now be able to invest that capital with the private equity fund's affiliated hedge funds, ensuring that the investor's capital stays in-house. Otherwise, if the capital is returned to the investor, there is a strong possibility that the investor will decide to invest it elsewhere. The ability to leverage a firm's existing client base by providing investors with a range of investment alternatives can be quite advantageous to an asset management firm. Many private equity firms, including KKR, Carlyle, Texas Pacific, Blackstone, and Bain, have launched their own hedge funds to embrace the opportunities associated with convergence.

Greater Efficiencies. Combining hedge funds and private equity funds under one roof also may promote efficiencies in attracting talent and raising capital. These two types of funds generally compete on two main fronts: talent and money. Both strive to attract the best and brightest in the financial services industry, and both offer opportunities that allow entrants to succeed if they perform very well. As a result, people in the financial markets who are eager to earn a lot of money typically will gravitate toward working for or starting either a hedge fund or a private equity fund.

Moreover, both hedge funds and private equity funds typically are lumped into the alternative asset class. Institutional and high-net-worth investors looking to invest in this asset class generally divide their capital between the two types of funds, which puts the fund managers head to head against each other when trying to raise capital.

Potential Drawbacks

But can the convergence of these two groups work smoothly? While an affiliation between these sectors seems appealing at first glance, there are some potential issues that must be addressed before these industries move toward convergence.

Style of Investing. Although hedge funds historically have flourished in the industries they have entered, investing in private equity funds involves much more than selecting and trading stocks and other securities. Private equity investing requires a different mindset and set of skills. It requires investing in a company for the long haul and creating value in that company through hands-on management of the company's operations and strategic direction. For fund managers, this typically includes taking a seat on the company's board of directors or being one of the officers of the company and working day after day to build the value of the company.

Hedge funds currently may lack the skills or experience to turn around or build private companies successfully. They also may lack the in-house talent required to close complex private equity deals, which can take up to many months to put together and typically involve the compilation of numerous legal documents and consultation with lawyers, bankers, accountants, and other industry professionals. Hedge fund managers are very good at detecting the pricing inefficiencies in a company's traded financial instruments. But they may not have the "right stuff" when it comes to creating value in a company through hands-on leadership.

Finally, hedge fund managers' lack of knowledge of the private market and their need to invest huge amounts of capital create concerns among private equity firms that deal prices will inflate irrationally, causing reduced returns.

Valuation. Hedge funds currently are structured in a way that requires them to periodically strike a net asset value to allow their investors to either purchase interests or redeem out of the fund based on that net asset value. Striking a net asset value is fairly straightforward when a fund's investments include publicly traded and other fairly liquid assets. However, determining the fair value for a private company that has little liquidity may be problematic. Values obtained are priced based on the manager's best estimates, and assumptions are fairly subjective. Although some industry guidance on valuing investments is available, such as the PEIGG's U.S. Private Equity Valuation Guidelines, the process by its nature is more subjective.

In addition, most hedge funds earn a performance fee either on an annual basis or at the time an investor redeems out of the fund. This has been acceptable to investors in cases where the value of the investment is easily determined and marketable. But investors may balk at being charged a performance fee in cases where the price of that investment is highly subjective and not based on actual market trading and movements.

Private equity funds have tackled this issue through distributions based solely on realized events and the use of "clawback" provisions that would generally require the private equity fund to return performance fees if the fund subsequently goes into a loss position. But such practices have generally been nonexistent in the hedge fund industry. Paying annual fees on locked-up money invested in illiquid securities with no readily determinable market value may be highly objectionable to many hedge fund investors.

Accounting and Liquidity Concerns. A hedge fund that has a large portion of its assets in private equity investments will encounter some complexities in accounting for those investments. Since most hedge funds provide monthly-to-quarterly liquidity to their investors, having private equity investments may necessitate the creation of "side pockets" to account for those transactions. "Side pockets" are created as a separate class of capital in a hedge fund to account for an illiquid security. They usually don't earn performance fees and are non-redeemable until the investment is realized. Accounting for two economic streams can be tricky and quite complex, especially when private equity investments make up more and more of the fund's net assets.

Moreover, when more of the fund's investments are in illiquid securities, the hedge fund will be under cash-flow pressure if investors decide to redeem some of their capital out of the fund. A hedge fund may find itself in a cash crunch if it does not have enough of its assets invested in liquid securities to cover the redemptions requested by its investors. To avoid liquidity issues, hedge funds historically have limited their investments in private equity to less than 30% of their net asset value.

Culture. The cultures of hedge funds and private equity firms have been quite different because various types of people gravitate to each of these industries. Private equity firms have tended to attract bankers and people who are good at running the operations of a company. Hedge funds, in contrast, have attracted traders and others from the investment banking houses who are more interested in short-term investing strategies. Bringing these two disciplines together under one roof may cause a culture clash.

Hedge fund managers may not be so eager to share equity in a firm with private equity principals, who may have long-term liability risks arising out of the clawback provisions in their funds. Structuring a compensation plan for all partners may be quite difficult because hedge fund managers typically generate their fees on an annual basis, while private equity managers typically earn their fees either at the close of an investment or at the close of the fund, which may take several years.

Furthermore, a firm that markets both hedge funds and private equity funds to its investors may encounter issues with marketing the performance records of these funds, since success in one arena does not imply success in the other. A private equity fund may have a sterling long-term track record in its own field, but when it adds a hedge fund to its firm, its historic private equity returns may not be a relevant indicator of future success in its hedge funds.

How Will Convergence Occur?

Some funds have admitted that they prefer to stick to their knitting, where their expertise is best put to use, and satisfy their urge to provide their investors with diverse investment opportunities by structuring funds of funds that invest in sectors outside the core business. By doing so, firms will not stretch their resources and overreach their limits, as they rely on the investee fund managers' work and expertise, while providing their investors with "tailored" funds of funds that address specific client needs.

Some funds that want to expand, but fear the loss of specialization, have acquired managers with skill sets in fields that parallel the core business of their firm. For example, a private equity buyout fund focusing in mid-market companies may open a hedge fund trading in mid-cap securities. The firm's background and its historic knowledge of specific industries or types of investments will support its efforts to market the new product as a logical extension of its current core business, and the assumed similarities in the managers' backgrounds may help to smooth the convergence process.

Increased use of side pockets in hedge funds and stepped-up investing in derivatives within the structure of private equity funds are other emerging trends.

When the Dust Settles

Although it is clear that two asset classes are gradually coming together, it's unclear what the terrain will look like once the dust settles. Some industry insiders believe that some type of hybrid vehicle will emerge that will include private equity investing but have more of a hedge fund structure. Others believe that combining these two investing styles will be very difficult because of the numerous hurdles each party would have to overcome, but that it makes sense that both these investing styles reside under one roof as multi-strategy investment funds. As these industries move closer together, it will be increasingly important for hedge funds and private equity funds to continue to focus their efforts on what they do well.

George Saffayeh, (212) 773-2430, george.saffayeh@ey.com, and Guy Lotem, (212) 773-9183, guy.lotem@ey.com, are senior managers in Ernst & Young's Financial Services Office.

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.

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